Keynes vs. Hayek: Who's the Winner?

Highlights

A recent BCA report (The Bank Credit Analyst, December 2012) has examined the relevance of the views of John Maynard Keynes and his followers and those of Friedrich von Hayek (a leader of the Austrian school) for the 2008-09 financial crisis. It comes down squarely on the side of the Keynesean school as offering the more accurate prescription.

The BCA report points out predictions of the Austrian school about large budget deficits and massive money printing leading to inflation and rising interest rates have not materialized. It also contends that fiscal multipliers are much higher than most economists believed just a few years ago, buttressing the Keynesean view.

I maintain it is important to separate the causes of the financial crisis from the cures. Thus, I believe some criticisms of the Austrian followers about Fed policy contributing to the housing bubble are valid. However, once the bubble burst the Fed's decision to flood the system with liquidity was critical to stabilize the situation.

It is very difficult to disentangle the effects of fiscal and monetary policies during the recovery phase. However, I suspect monetary stimulus was more important than fiscal stimulus in promoting recovery. That said, the Fed should heed the warnings of the Austrian camp about unintended consequences of maintaining artificially low interest rates indefinitely.

Reviving an Old Debate

In a recent report entitled "Hayek vs. Keynes: Weighing the Evidence", Peter Berzen, Managing Editor of BCA, resurrects a debate that occurred in the early 1930s between John Maynard Keynes and Friedrich von Hayek about the role government should play in overcoming a severe economic downturn. Keynes believed that the Great Depression was caused by insufficient demand from the private sector (both households and businesses) and favored government policies that would boost overall spending and end mass unemployment. In contrast, Hayek argued that the best way to destroy capitalism was to debauch the currency, and he argued that pro-active fiscal and monetary policies would worsen the Depression.

By the 1960s, the prevailing view in the economics profession was that massive spending during WWII was the catalyst for ending the Depression, and Keynesean economics became mainstream. During the 1970s, however, one of the cornerstones of Keynesean theorizing – the idea that there was a stable trade-off between inflation and unemployment – was called into question when expansionary fiscal and monetary policies fueled high inflation. According to Berzen's characterization, Keynesean economists and their detractors were stuck in a stalemate until the financial crisis ended the détente, with both sides – Keyneseans and Austrians – accusing each other of ignoring the lessons of history.

Against this backdrop, Berzen asks the question, "Who has the better case?" His answer is based on which theory has offered the most accurate predictions over the past five years, the Keynesean school wins hands down. The basis for his conclusion is that Hayek's followers made three predictions, none of which has panned out:

Rising budget deficits would lead to soaring interest rates.

Massive "money printing” by the Fed and other central banks would cause runaway inflation.

Fiscal austerity would boost growth by raising household and business confidence.

At the same time, Berzen argues that stimulative fiscal policies have been more effective in supporting the economy than is generally recognized:

"A variety of studies clearly suggest that fiscal stimulus programs both in the U.S. and abroad were successful in boosting growth. If anything, the evidence indicates that fiscal multipliers are much higher than what most economists believed just a few years ago. A recent report by the IMF, for example, indicates that fiscal multipliers are in the range of 0.9-1.7, up from an initial estimate of 0.5."

What Caused the Housing Bubble and Financial Crisis?

My response is that the BCA report does a credible job laying out the differences in the two schools about how to respond to a severe economic downturn. However, it fails to consider what factors contributed to the 2008-09 financial crisis.

According to followers of the Austrian school, the main factor contributing to the crisis was over-investment in residential housing that was accommodated by lax monetary policy. In their view, the Federal Reserve kept interest rates artificially low in the aftermath of the tech bubble, which resulted in rapid credit expansion that fueled the surge in housing prices. Once the housing bubble burst, the proponents of the Austrian school contend market forces should be allowed to play themselves out until a new equilibrium is established.

Keyneseans, by comparison, see the housing bubble resulting from "animal spirits", or greed and speculation. Once the bubble burst and fear became the dominant driver of private sector behavior, they argue it was necessary for government to fill the void, increasing public spending to offset the decline in demand from the private sector. In their view, the financial crisis represented a situation in which the banking system had seized up, and the economy could not be stabilized by relying solely on market forces.

My Assessment of the Situation

My own take is that two sets of forces were at play. First, the Fed contributed to the bubble by pursuing overly easy monetary policies. However, once the bubble burst and financial institutions failed, the Fed acted correctly by supplying ample liquidity to the banking system. The argument that the latter action was equivalent to printing money is not correct: While the Fed created reserves for the banking system to lessen the risk of a run on financial institutions, the money supply did not expand, because the banks chose to hold excess reserves rather than extend new loans. Consequently, the process of reserve creation was not inflationary. In this regard, I concur with BCA's assessment that the Austrian school's prognostications were incorrect.

I am less convinced, however, by BCA's argument that expansionary fiscal policy was more effective than is widely recognized. I believe it is inherently difficult to separate the effects of monetary and fiscal policies soon after the financial crisis unfolded. Had the Fed failed to inject reserves into the financial system, for example, it could have become destabilized to the point where fiscal policy would have had only limited effect. This point is illustrated by Japan's experience following the burst of the stock market and real estate bubbles in the early 1990s: Japan's economy barely grew then despite massive government spending, mainly because monetary policy remained too restrictive. Consequently, I suspect monetary policy played a greater role in reviving the economy than BCA contends, and I am skeptical that increased government spending has had a long-term impact on the U.S. economy.

Finally, while I give the Fed and Chairman Bernanke, in particular, credit for saving the financial system following the collapse of Lehman Brothers, I am concerned that Fed policy is now centered on achieving a significant decline in the unemployment rate to below 7%. First, I question whether the Fed can achieve this objective. Second, I am worried about what will happen in financial markets when the period of ultra low interest rates comes to an end. In a previous commentary, I highlighted the research of William White of the BIS, who has cautioned about the unintended consequences of keeping interest rates artificially low indefinitely. In my opinion, the Federal Reserve should heed his warnings before the seeds are sown for another asset bubble.

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